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ABC Beverage leased a plant in Hazelwood, Missouri for bottling Dr. Pepper and Snapple soft drinks. The rents the company was paying under the lease were above market: for example, it paid $1.1 million in rent in 1997 compared to $356,000 that an appraiser said would have been the market rent.

ABC had an option to purchase the plant for its fair market value. It offered the landlord $9 million. The landlord countered with $14.8 million. The parties settled on $11 million.

ABC had three independent appraisals, all of which concluded that the plant had a fair market value of only $2.75 million. Consequently, ABC treated its purchase price for the plant as $2.75 million and deducted the balance of $6.25 million as a payment to cancel the disadvantageous lease. Lease termination payments are deductible immediately.

The government conceded that the amount could have been deducted if ABC had terminated the lease without also buying the plant, but said the entire $11 million should be treated as the purchase price for the plant.

A US appeals court disagreed.

Section 167(c)(2) of the US tax code says that someone buying a building or other property “subject to a lease” should treat the entire amount paid as purchase price for the building.

The court said the section does not apply since the phrase “property acquired subject to a lease” does not cover a situation where the lessee buys out the lease while acquiring the property. The lease disappeared with the purchase.

The court said, “The government concedes that ABC could deduct a lease termination payment if it first pays to terminate the lease and then purchases the property. But that concession and this transaction have the same substance . . . . We decline to elevate this transaction’s form over its substance.”

The case is ABC Beverage Corporation v. United States. The court released its decision in June.

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